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# Portfolio / Cost of Capital

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Please explain each problem and provide analysis and suggestions. Also please mark the answers corresponding to the number and/or letter of the question.

1. Determining Portfolio Weights: What are the portfolio weights for a portfolio that has 100 shares of Stock A that sell for \$40 per share and 130 shares of Stock B that sell for \$22 per share?

2. Portfolio Expected Return: You own a portfolio that is 50 percent invested in Stock X, 30 percent in Stock Y, and 20 percent in Stock Z. The expected returns on these three stocks are 10 percent, 16 percent, and 12 percent, respectively. What is the expected return on the portfolio?

3. Calculating Expected Return: Based on the following information, calculate the expected return:
State of Economy Probability of State of Economy Rate of Return if State
Occurs
Recession .30 -.09
Boom .70 .33

4. Calculating Returns and Standard Deviations: Based on the following information, calculate the expected return and standard deviation for the two stocks:

State of Economy Probability of State of Economy Rate of Return if State Occurs
Stock A Stock B
Recession .15 .06 -.20
Normal .60 .07 .13
Boom .25 .11 .33

5. Calculating cost of equity: The Mays Co. just issued a dividend of \$2.60 per share on its common stock. The company is expected to maintain a constant 6 percent growth rate in its dividends indefinitely. If the stock sells for \$60 a share, what is the company's cost of equity?

6. Calculating cost of equity: Stock in Country Road Industries has a beta of 1.25. the market risk premium is 7 percent, and T-bills are currently yielding 5 percent. Country Road's most recent dividend was \$2.10 per share, and dividends are expected to grow at a 5 percent annual rate indefinitely. If the stock sells for \$34 per share, what is your best estimate of the company's cost of equity

7. Calculating Cost of Preferred Stock: Holdup Bank has an issue of preferred stock with a \$5 stated dividend that just sold for \$87 per share. What is the bank's cost of preferred stock?

8. Calculating Cost of Debt: Jiminy's Cricket Farm issued a 30-year, 9 percent semiannual bond 7 years ago. The bond currently sells for 108 percent of its face value. The company's tax rate is 35 percent.
a. What is the pretax cost of debt?
b. What is the aftertax cost of debt?
c. Which is more relevant, the pretax or the aftertax cost of debt? Why?

9. Calculating WACC: Mullineaux Corporation has a target capital structure of 50 percent common stock, 5 percent preferred stock, and 45 percent debt. Its cost of equity is 15 percent , the cost of preferred stock is 6 percent, and the cost of debt is 8 percent. The relevant tax rate is 35 percent.
a. What is Mullineaux's WACC?
b. The company president has approached you about Mullineaux's capital structure. He wants to know why the company doesn't use more preferred stock financing because it costs less than debt. What would you tell the president?

#### Solution Summary

The solution explains various questions relating to returns and standard deviation of a portfolio and calculation of cost of capital

\$2.19

## Financial management: required return, beta, terminal value, WACC, project selection

8-16
You have been managing a 5 million portfolio that has a beta of 1.25 and a required rate of return of 12%. the current risk free rate is 5.25%. assume that you receive another 500,000. If you invest the money in a stock with a beta of 0.75, what will be the required return on your 5.5 million portfolio?

9-15
Dozier Corporation is a fast growing supplier of office products. Analysts project the following free cash flows (FCFs) during the enxt 3 years, after which FCF is expected to grow to a constant 7% rate. Dozier's WACC is 13%.

Year: 0=NA Year 1= -20Millon Year 2= 30 Million Year 3= 40 Million

a. What is Dozier's terminal, or horizon, value? (hint. find the value of all free cash flows beyond year 3 discounted back to year 3)?
b. What is the firms value today?
c. Suppose dozier has 100 Million of debt and 10 Million shares of stock outstanding. What is your estimate of the current price per share?

10-9
The Patrick company's cost of common equity is 16%, its before tax cost of debtr is 13%, and its marginal tax rate is 40%. The stock sells at book value. using the following balance sheet, calculate Patricks WACC.

Assets:
cash=120
acct receivables=240
inventories=360
plant and equip net=2,160
total assets=2,880

Liabilities and Equity
long-term debt=1,152
common equity=1,728
total liabilities and equity=2,880

10-12
WACC. Midwest electric company MEC uses only debt and common equity. It can borrow unlimited amounts at an interest rate of rd=10% as long as it finances at its target capital structure, which calls for 45% debt and 55% common equity. Its last dividend was \$2, its expected constant growth rate is 4%, and its common stock sells for \$20. MEC tx rate is 40%. Two projects are available: Project A has a rate of return of 13%, while Project B's return is 10%. These two projects are equallly risky and about as risky as the firms existing needs.

a. What is the cost of common equity?
b. What is the WACC?
c. Which Project should Midwest accept?

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